Magazine

Online Extra: KB Home: Cyclical No Longer?

April 04, 2004

By Christopher Palmeri Twelve of the nation's largest publicly traded homebuilders, including Lennar (LEN), Pulte (PHM), and Centex (CRX), are working together on a campaign to change the perception that they're cyclical, interest rate-dependent companies prone to booms and busts. On Mar. 17, Bruce E. Karatz, chairman and CEO of KB Home (KBH), confirmed the unusual strategy and told investors that the days of small local builders piling on debt and getting clobbered when rates rise are over. "The industry is still viewed the way it was 20 or 30 years ago," Karatz said. "[It] has matured tremendously since those early days."

Notwithstanding the industry's preemptive approach in a year when rates will most likely rise, KB Home has much to boast about. Karatz has taken steps to put the Los Angeles-based builder in some of the fastest-growing home markets in the nation, including booming Sunbelt cities like Phoenix, San Antonio, and Las Vegas. KB specializes in entry-level homes, often for the country's growing base of Hispanic buyers. It has also been targeting empty-nesters with townhouses and other smaller dwellings near urban centers.

BATTLING CYCLICALITY. These strategies have paid off. KB's profits have jumped at an annual average 23.2% rate over the last three years, a feat that helped land it on BusinessWeek's annual list of the 50 top-performing companies at No. 48.

KB just reported another bang-up quarter, with earnings rising 40%, to $74 million, on a 24% increase in sales, to $1.3 billion. It now has some 16,600 homes on order, at a total value of $3.7 billion. Karatz bumped up KB's earnings projections to $10.25 per share, a 16% gain from 2003. Despite that performance, KB trades at just 7.5 times what analysts expect it to earn for 2004, according to an estimate compilation from Reuters Research. That's low, even for homebuilders, which trade at an average 11 times expected 2004 earnings.

Homebuilders today are better positioned to manage the cyclical nature of the business than in years past, Karatz argues. Companies like KB have snapped up smaller regional rivals, giving themselves geographic diversification and economies of scale. They hold far less raw land than they used to. Many now sport investment-grade debt ratings. Through the increasing use of computers and other companywide practices, they also operate more efficiently.

SIGNAL TO SELL? Not everyone is convinced that homebuilders can forever shake their cyclicality. Barbara Allen, a long-time construction analyst at brokerage firm Natexis Bleichroder says KB's current valuation at nearly twice book value is a signal to sell. She calculates the downside risk of more than 35% if interest rates rise and new-home sales fall. KB is particularly vulnerable because its many first-time buyers may get shut out of the market when rates go up. Allen figures KB's earnings will dip to $9 per share next year.

Karatz naturally disagrees: "Our management team believes the next five years will be seen as the best in the company's history." In this environment, when most analysts predict home sales will flatten at best and likely decline as rates rise, delivering on that unbridled enthusiasm may be tricky. Still, over the long haul, KB Home may be a good place for investors who want a stake in this industry. Palmeri is a correspondent in BusinessWeek's Los Angeles bureau